INTRODUCTION TO REAL ESTATE AS AN INVESTMENT 
INTRODUCTION TO REAL ESTATE AS AN INVESTMENT
INTRODUCTION
Why do people invest in real estate? Investment motives are as diverse as the investors who acquire real estate.
I. DISTINCTIVE CHARACTERISTICS OF REAL ESTATE AS AN INVESTMENT VEHICLE
Real estate, as an investment, is generally regarded as having certain distinctive characteristic that distinguish it from other investments such as stocks and bonds.
A. Investment Size
1. Securities (stocks and bonds) can usually be purchased with relatively small amounts of cash.
2. Real estate investments generally require relatively large amounts of cash, both equity and debt.
B. Holding Period
1. Securities can usually be purchased and sold relatively quickly.
2. Marketing real estate and the legal requirements of transferring real property generally involves substantially greater amounts of time.
C. Complexity of Transfer Mechanism
1. With securities, an investor can usually open an account with a stockbroker and begin trading very quickly.
2. The purchase, sale, and financing of real estate usually:
a. Involves numerous legal documents, financial institutions, government regulations, etc.
b. Requires many other parties to effect a real estate purchase, e.g., appraisers, brokers, Insurance salesmen, attorneys, title companies, escrow companies, etc.
D. No Formal Market Structure
1. Many securities (and commodities) are traded on organized, centralized exchanges, such as the New York Stock Exchange.
2. There are numerous large brokerage houses organized to aid in the purchase and sale of such securities.
3. Similar institutionalized exchanges and large national brokerage houses do not exist to facilitate the sale or exchange of real estate.
4. Real estate purchases and sales are usually handled on an individual basis.
E. Absence of Standardized Performance Information
1. With respect to securities investments there are:
a. Numerous statistics and averages kept with respect to their performance.
b. Numerous, widely circulated, publications (i.e., Wall Street Journal) reporting information relevant to making such Investments.
2. Information about real estate and the performance of such investments is more difficult to obtain and generally reported on a less standardized and more irregular basis.
F. Uniqueness of Each Parcel of Real Estate
1. Each parcel of real estate is situated in a different location.
2. The “uniqueness” in location makes reliance on quantitative data alone insufficient analysis of a proposed investment requires a physical Inspection.
Entrepreneurial Potential
1. Once the purchase of securities (stocks and bonds) is made, the securities investor remains relatively passive.
2. The real estate investor need not remain passive and can initiate activities with respect to the investment such as renovation, subdivisions, rezoning, implementation of new management and marketing plans, etc.
II. REAL ESTATE INVESTMENT ADVANTAGES AND RETURNS
A. Profit (Return)
An investment in income producing property can produce the following four returns:
1. Cash flow the cash available from operations after all cash expenditures of every kind have been disbursed (other than income taxes), including payments on the loan encumbering the property.
2. Equity build up increases in equity ownership as a result of loan amortization (i.e., principal reduction).
a. Equity buildup is not a spendable component of return.
b. When the property is sold, the investor owes less on the loan, thus receiving more cash at closing.
3. Tax shelter tax losses which can be applied to shelter income from the property and also from other sources as well (subject to certain limitations).
4. Appreciation refers to an increase in the value of the property over time.
a. Some of the increase in the property's value may be due to inflation.
b. Some of the increase may result from changes in the supply and demand forces in the real estate market.
B. Leverage
1. One of the major attractions of real estate is the investor's ability to control a large asset with a relatively small amount of equity capital.
2. Investments in real estate are generally made with the use of a considerable amount of borrowed funds referred to as “leveraging”.
3. If the return on total capital invested (equity and debt) is greater than the cost of the borrowed capital, the ability to leverage the investment gives the investor additional return on his invested capital ("equity") that would not otherwise be possible.
Inflation Hedge
1. Historically, real estate has been a good inflation hedge i.e., an investment whose return equals or exceeds the rate of inflation over long periods of time.
2. Also, it has been quite common for commercial real estate leases to include escalation clauses permitting the pass through of increased costs and increasing rents as the Consumer Price Index increases.
D. Personal Control (or Responsiveness to Entrepreneurial Efforts)
1. Real estate can be improved, renovated, and subdivided and rents and sales prices can be affected by the owner's labor and capital inputs.
2. Examples purchasing and restoring “fixer uppers;” converting existing properties, such as an apartments building, to new uses such as condominiums.
E. Self Use and Occupancy
1. Many investors acquire real estate for their own use.
2. Examples:
a. A single family dwelling is a form of investment that provides physical shelter, a tax shelter, and appreciation in property value. The ownership and occupation of a duplex, triplex, etc.
b. An investor occupant of a manufacturing plant benefits in a similar way. Medical doctors and dentists often prefer to own facilities designed to meet their particular needs.
F. Diversification (Real Estate as a Portfolio Asset)
1. The risk of loss can be reduced by diversification into investments with different financial characteristics than those currently in an investor's portfolio.
G. Income Tax Factors
Depreciation
a. The investor may recover a substantial portion of his cost of real estate (other than land) through the depreciation deduction.
b. The amount subject to depreciation includes funds invested and may include funds borrowed to acquire the property.
This allows an investor to purchase real estate through partial debt financing and to fund debt repayment, in part, with cash generated by the depreciation deduction.
2. Interest on mortgages and property taxes
a. The major out of pocket costs to carry real estate (whether improved or unimproved) are deductible and help create some of the tax benefits applicable to holding real estate.
b. These costs include interest, taxes, insurance, and management fees.
3. Expensing maintenance and repairs.
a. The owners of investment real estate can deduct all costs for repairs, operations and maintenance to keep the property in sound condition.
4. Tenant Improvements (T.I.’s)
a. Improvements made by the tenant of property do not constitute income to the owner unless the improvements are intended to reduce the rental rate.
b. This allows the owner another means of increasing the property capital value when tenant improvements revert to the owner upon termination of the lease. The owner may thus, realize an increase in net worth at no tax cost.
5. Flexibility of title and ownership title to real estate can be held in a number of different ways (corporations, partnerships, LLC’s), depending upon the intent of the parties and their tax objectives.
6. Tax deferred exchanges.
a. Section 1031 of the U.S. Tax Code allows real estate investors under certain conditions, to exchange equity from one real estate investment to another and defer any capital gains, which would have been recognized in a normal sale.
b. One of the most important advantages to a real estate owner is the ability to trade his equity in a property for equity in a more expensive property at no current tax cost.
7. Installment Sale
a. Real estate if often sold on a deferred payment basis. The Owner/seller may receive a note secured by a deed of trust from the buyer which is payable over a number of years.
8. Refinancing An owner may refinance a property and generate cash tax-free.
III. REAL ESTATE DISADVANTAGES AND RISKS
There are significant disadvantages and risks associated with real estate investments.
A. Lack of Liquidity
1. Real Estate is generally not considered to be liquid. Liquidity is the ability to convert an investment into cash quickly and with little, if any, loss of principal.
a. The product is not standardized or traded on an exchange – time is required for a prospective buyer to inspect and evaluate a property.
b. Time is required to expose and advertise the property, negotiate the sale, obtain title search, arrange financing, and close escrow.
2. Refinancing Financing may not always be available. Higher interest rates may make refinancing less feasible.
3. Some types of real estate are generally more liquid than others.
a. A single family home in highly desirable area is generally more liquid than, say, a resort condominium in the mountains, because a broader market usually exists for primary residences than for second homes.
b. The market for special or single purpose properties (e.g., manufacturing facilities, theaters, bowling alleys, etc.) is relatively “thin” i.e., there are few buyers and sellers and there is relatively low turnover for such properties.
B. Necessity of Management
1. In general, most income producing properties require a significant amount of personal attention compared with other types of investments.
2. Whether the property is managed by the owner or through a management company, constant attention must be given to the property to maintain its income and value.
3. Many investors find property management an unpalatable aspect of real estate investment.
Lack of Information
1. The information essential to good investment decisions is usually imprecise, hard to find, and likely to be inaccurate.
2. Investment decisions are often made with inadequate data and are many times based on “gut feels”
Legal Complexity
1. The contracts between parties (e.g., buyer seller, borrower lender, etc.) are usually complex (and ofter require expert opinions from attorney’s, consultants and brokers).
2. The tax laws that impact real estate are also complex and change frequently and unpredictably.
Risk
Risk refers to the degree of certainty with which return from the investment is expected; risk may be further defined according to type, as discussed below.
2. Business risk.
a. The greater the potential variability between projected (pro forma) and actual net operating income produced by the property, the greater the business risk.
c. Sources of business risk may be both internal (i.e., poor management) and external (changes in supply and/or demand factors, rent controls, etc.).
3. Financial risks.
a. Relates to the capital structure of the project, i.e., the relationship between debt and equity.
b. It is measured in terms of the uncertainty of the property's financial ability to produce annual net operating income sufficient to cover the loan payments.
c. Personal recourse on loans
4. Interest rates risk.
a. Refers to the degree of uncertainty associated with the likelihood of changes in the future level of interest rates and the impact such changes have on property values.
b. To the degree that changes in the general level of interest rates affect capitalization rates, a small change in interest rates causes large variations in property values.
APARTMENT BUILDING INVESTMENTS
I. “APARTMENT BUILDING” DEFINED
A building designed for the separate housing of two or more families and where services are supplied for convenient occupancy.
II. TYPES OF APARTMENT BUILDINGS
Multi unit rental housing is often classified partly by developmental density and partially by architectural style.
A. Low Rise Apartment Building
1. Usually not more than five stories high those with more than three stories are usually equipped with elevators.
2. Types of low rise apartments.
Traditional urban walk up buildings
- Mostly found in older cities where smaller sites necessitate high building density. Stairways or elevators provide access to upper floors.
- Amenities are usually limited.
- Parking on site is often limited.
Garden style apartments
- Usually two or three story walk up buildings.
- Usually located in suburban areas.
- Grounds are usually extensively landscaped and have such common area amenities as swimming pools, tennis courts, health club facilities, clubhouses, and covered parking. Relatively low density of units.
Townhouses
- Usually two stories in height.
- Shares a common side wall with neighboring units but usually has its own front and rear entrances.
- Some units may also provide patios and garages or carports.
- Ample parking together with shared recreational facilities are often major features. Parking may be available underground.
B. Mid Rise Apartment Building
1. Ranges from six to nine stories and is found in both cities and suburbs.
2. Standard features usually include elevator service, central lobby, trash chutes, and laundry storage rooms; all units open onto a common central hallway on each floor.
a. Some projects provide a wide range of amenities such as pools, clubhouses, and health club facilities.
C. High-rise Apartment Building
1. Structure at least 10 stories in height, usually located in a major metropolitan area.
2. Similar to a mid rise in construction and layout.
3. In addition to standard amenities, mid rise buildings often provide extra amenities, such as a security guard, parking garage, maid and valet service, etc.
4. More costly to operate than mid-rise and low-rise buildings.
III. ADVANTAGES AND DISADVANTAGES OF MULTI-FAMILY INVESTMENTS (VS. OTHER PROPERTY TYPES)
A. Advantages:
1. Good leverage generally higher loan to value loans available; seller carried financing is common.
2. Tax shelter (for the small investor) shorter depreciation period (27.5 years vs. 39 years); usually lower land/building ratio – so more to depreciate.
3. Generally good resale market may vary, depending on location, number of units, etc.
4. Less sophistication required in operating the property.
5. Broad rental market.
6. Greater variety in sizes (2 units to 1,000+ units)
7. Responsiveness to entrepreneurial efforts short-term aggressive management can have a significant effect.
8. Rents are generally not controlled by long term leases (disadvantage in down market, advantage in up market).
B. Disadvantages:
1. Relatively low annual operating cash flow potential (initially).
2. Higher demands for management time.
3. No key or anchor tenants to provide stability of cash flow.
4. No security of long term leases.
5. No automatic rental increases tied to C.P.I., etc.
6. Expenses not passed through to tenants contractually. Master metered buildings can be nightmares. Also galvanized plumbing, “brickers”, and flat roofs.
Greater exposure to government regulations, e.g., rent control, code enforcement, etc.
8. Eviction process can be uncomfortable.
SHOPPING CENTER INVESTMENTS
I. “SHOPPING CENTER” (RETAIL) DEFINED
A group of commercial establishments planned, developed, owned, and managed as a unit related in location, size and type of shops to the trade area that the unit serves; it provides on site parking in definite relationship to the types and sizes of stores.
II. TYPES OF RETAIL FACILITIES
As the shopping center evolved, five basic types emerged: the strip, the neighborhood, the community, the regional, and the super regional. In addition, other terms are commonly used to describe different types of retail facilities.
Strip Centers:
1. Convenience (or “strip”) center.
a. Group of 6 to 12 stores with parking in front.
Often anchored by a “quick stop” market such as 7-Eleven.
Often has insufficient parking.
B. Neighborhood Centers:
1. Provides for the sale of convenience goods and personal services.
2. Generally anchored by a supermarket and/or a large drug store.
3. Typical drawing radius is about 1.5 miles in a densely populated area.
4. Range in size from 75,000 to 150,000 square feet of GLA.
5. Cover from 4 to 10 acres of land.
C. Community Centers:
1. Offer convenience goods and personal services (laundry and dry cleaning, shoe repair, etc.) as well as a range of facilities for the sale of goods such as furniture, appliances, clothing, hardware, etc.
2. Usually anchored by a junior department store, variety store, discount department store, or a major hardware store.
3. Trade area in a highly dense region is up to a radius of about 3 miles, or about a 5 minute drive time.
4. Range in size from 100,000 to 300,000 square feet of GLA.
5. Most of the sites cover an area from 10 to 30 acres.
D. Regional Centers:
1. Provide a wide range of shopper and convenience goods (food, drugs, and sundries) as well as specialized and personal services and in some cases, recreational facilities.
2. Anchored by 1 or 2 full line department stores of generally not less than 100,000 square feet of GLA each.
3. Typical trade area is about 8 miles.
4. Generally 300,000 to 1,000,000 square feet of GLA.
5. Cover 30 to 50 acres of land area.
E. Super Regional Centers:
1. Provide an extensive variety and depth of shopping goods (an item that consumers drill-shop around for, such as a suit, a plasma TV, or an item of furniture), services, and recreational facilities.
2. Anchored with at least three full line department stores of not less than 100,000 square feet.
3. May contain a total area of more than 1,000,000 square feet of gross leasable area (GLA).
4. Cover up to 100 acres of land.
F. Other Types of Retail Facilities
1. Specialty center.
a. Contains no department store or supermarket anchor.
b. Developed around a special theme often through use of existing structures, such as an old factory or a marketplace.
c. Can range from 40,000 to 300,000 square feet of GLA.
d. Tenants are generally small (400 to 2,000 square feet), primarily in the areas of clothing, household, and specialty goods.
e. Restaurants and gourmet food outlets are often a major element Entertainment Facilities, such as theaters, may also be included.
2. Freestanding stores.
a. A store not located in shopping or strip center.
Can range from a 2,000 square foot delicatessen to a 500,000 or more square foot discount department store.
Known as a single tenant NNN investment.
3. Outlet center.
a. A collection of factory outlet stores, usually with no anchor tenant.
b. Regional in scope and often has a strong base of tourists as customers.
III. ADVANTAGES AND DISADVANTAGES OF SHOPPING CENTER INVESTMENTS
A. Advantages:
1. Usually have good cash flow potential going in.
2. More tenant stability longer term leases.
3. Usually less management intensive.
4. Usually more financially stable tenants.
5. Usually more able to keep up with inflation because of escalation and overage rent clauses in leases.
6. Easier to finance and refinance, especially if center has strong anchor tenants.
7. Increased tax shelter if land is leased.
8. A monopoly opportunity if neighboring land is unavailable.
B. Disadvantages:
1. High risk of obsolescence.
2. Usually unattractive leverage going in.
3. Owner shares risk of tenant business failure (percentage lease).
5. Closer and more complex relationship with tenants.
6. Takes a longer time to raise rents and take advantage of “upside” potential.
OFFICE BUILDING INVESTMENTS
I. “OFFICE BUILDING DEFINED”
A single or multi story building devoted primarily to conducting non retail business and/or services activities.
II. TYPES OF OFFICE BUILDINGS
A. High Rise Office Buildings
1. “High-rise” is an inexact term. Definition of “high rise” may vary from market to market.
2. Usually denotes a multi story building of steel frame construction.
B. Low or Mid Rise Office Building
1. Generally, a building not of steel frame construction.
2. Usually concrete construction, the height of which is regulated by construction limitations for concrete buildings.
C. Suburban (or Garden) Office Building
1. Usually a low-rise building located in an outlying suburb rather than in or near the urban core.
2. Typically landscaped and built to blend with its surroundings.
D. Medical Office Building
1. Building used by doctors, dentists, and other medical practitioners to offer services in one central location.
2. Often includes retail, (e.g., drugs)
3. Preferred location near a hospital
E. Other Types of “Office” Investments
1. Mixed use
a. Office use mixed with retail in same building
b. Retail generally occupies ground floor, with offices above
2. Owner user
a. A building in which the principal or exclusive tenant is the property owner
3. Office park
a. Usually located in park like setting in suburbs
b. Provides ample parking, as well as other amenities
c. Easy accessibility from residential areas
d. Tends to be located near major freeways, retail centers, and often near airports
III. ADVANTAGES AND DISADVANTAGES OF OFFICE BUILDING INVESTMENTS
A. Advantages
1. Higher potential returns (if “right” location and property is selected)
2. Relatively stable cash flow (from well-located buildings)
a. Key tenants can provide cash flow stability.
b. Standard leasing arrangements usually provided for periodic rent increases and protection from rising expenses
c. Less tenant mobility because of longer term leases
d. More financially stable tenants
3. Less management intensive
4. Opportunities for generating additional income, e.g., vending machines, food services, office services, parking, etc.
Usually can be purchased with higher operating cash flow at acquisition
B. Disadvantages
1. Higher ratio of operating expenses to revenues (than retail).
2. Higher land costs.
3. Usually less attractive leverage at acquisition (unless building has high quality tenants).
4. Less attractive depreciation treatment (than multi-family) for income tax purposes.
5. Takes longer time to raise rents and take advantage of potential upside, because of leases.
6. Supply of competitive space is highly cyclical.
7. Tenants are more sophisticated in lease negotiations.
8. Tenants usually expect tenant improvements and substantial services.
INDUSTRIAL BUILDING INVESTMENTS
I. “INDUSTRIAL BUILDING” DEFINED
A building used for any of the following purposes: warehouse, manufacturing assembly, or research and development activities.
II. TYPES OF INDUSTRIAL BUILDINGS
Having similar characteristics to office, industrial properties may generally be classified as follows: (1) warehouse (2) manufacturing (3) research and development and (4) multi tenant “incubator”.
In addition, they can be further classified as: (1) multi tenant investments industrial building occupied on a multi tenant basis on short term leases (3 5 years); and (2) net leased investments industrial properties occupied by one tenant on a long term lease.
A. Warehouse
1. The least improved industrial space (maybe 5 10% offices).
2. Generally requires the least parking (1 2 spaces per 1,000 square feet of gross leasable area (GLA).
3. Has the highest building to land coverage factor (little to no parking needed).
4. Cubic square feet is important thus, ceiling heights are relevant (22 feet is most desirable).
B. Manufacturing
1. Building includes areas in which a product is assembled or manufactured.
2. Generally, contains more office space than warehouse properties (10 15%).
3. Requires more parking, thus, creating a lower building coverage factor (35 45%).
4. Requires lower ceilings, additional lighting, more air conditioning, electricity, plumbing, and thicker floor area, depending on whether the building is used for heavy or light manufacturing purpose.
C. Research and Development
1. Typically will have a large office area (25 50%).
2. Requires more parking (4 6 spaces per 1,000 square feet of GLA), therefore, creating a lower building coverage factor (30-35%).
3. High degree of tenant improvements
4. Leases tend to be longer, thus, properties are usually in the “net leased investment” category.
5. Generally, have more of an architectural design 20 25% of the front and side will usually be window area.
D. Multi Tenant Incubator
1. Accommodates the small industrial user (1,000 5,000 square feet).
2. Sometimes referred to as “incubator” buildings, because they provide small spaces to new companies.
3. Tenant space will usually contain anywhere from 5% to 100% office area.
4. Parking is usually 2 3 spaces per 1,000 square feet of GLA.
III. ADVANTAGES AND DISADVANTAGES OF INDUSTRIAL BUILDING
INVESTMENTS
A. Advantages
1. Stability of cash flow if the property is leased to a prime tenant.
2. Limited downside risk if leased to a prime tenant.
3. Minimal management responsibility if property is leased on triple net basis.
4. Reduced risk of landlord tenant problems.
5. Potential monopoly pricing if neighboring industrial land is unavailable.
6. Reduced sensitivity to neighborhood economic decline.
7. Tenants are usually less mobile because moving industrial equipment and inventory is very expensive, most industrial firms choose to minimize geographic movement as much as is consistent with efficient and profitable operations.
Disadvantages
1. Usually requires a relatively larger capital investment.
2. Relative lack of liquidity the more specialized the facility (e.g., special or single purpose), the less rapid the turnover. Also, the larger the facility, the more difficult to market, in most cases.
3. Higher exposure to government controls and regulations
4. High risk of functional obsolescence technological changes in industrial processes as well as construction or design can render industrial real estate facilities functionally obsolete quite rapidly.
5. Tenants are more sophisticated in lease negotiations.
6. Buildings are often single user, custom construction.
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